Keynote Address

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Date

May 1, 2014

Speaker

James R. Doty, Chairman

Event

Baruch College 13th Annual Financial Reporting Conference

Location

New York, NY

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Thank you for this opportunity to speak to you today. Year after year, the Zicklin Center facilitates deeply insightful discussions on current accounting and auditing issues among policy makers, auditors, preparers and academics.

This is rarefied air here at the top of Baruch's beautiful, vertical campus. But with Norm Strauss's guidance, the conference agenda deftly harnesses the intellectual power of the conference in the service of Baruch College's governing motto — "The American Dream Still Works!"

I believe the American dream indeed persists, but it requires labor and attention, as it always has. I intend to speak today about the role and prospects of the auditing profession in preserving that dream. The views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

We credit the Frenchman, Alexis de Tocqueville, with being the first to recognize this American dream, based on his travels in America in the early 1830s, to conduct research for a book on the American penal system. His tour was merely 25 years before the Prussian-born Simon Baruch would emigrate to South Carolina, become a doctor, marry an impoverished southern belle and raise four remarkably successful sons, including the renowned financier Bernard Baruch, whose own American dream conceived this wonderful institution.

What we best remember of de Tocqueville's journey is not what he set out to find, but what he discovered along the way. He wrote —

There is no man who cannot reasonably expect to attain the amenities of life, for each knows that, given love of work, his future is certain. . . . No one is fully contented with his present fortune, all are perpetually striving, in a thousand ways, to improve it. Consider one of them at any period of his life and he will be found engaged with some new project for the purpose of increasing what he has.[1]

De Tocqueville was a member of the landed gentry in France, an aristocrat who collected rents from tenant farmers. His father obtained for him a position as a judge at the court of Versailles. He lived in one of the most educated and advanced societies in the world at the time. Yet it was fraught with rebellion. When his patron king was exiled, he lost his paid commission.

He found in America the peaceful influence of free enterprise. He marveled, "I know of nothing more opposite to revolutionary attitudes than commercial ones. Commerce is naturally adverse to all the violent passions . . .."[2]

De Tocqueville wrote for a French audience, but in doing so he offered Americans a broad vision of themselves, founded on fairness and opportunity. Where he found fairness and opportunity, we thrived; where he did not — most importantly in the institution of slavery — we too trod the path to social upheaval.

On this moral foundation of fairness and opportunity, the American accounting profession was built. The presiding individualism that de Tocqueville recognized in early America created the perfect breeding ground for that most American of institutions —voluntarily-funded private enterprise made possible not by the Crown, but by (i) marshalling capital from numerous, dispersed individuals, (ii) hiring professional, trained management, and (iii) monitoring management's stewardship with the watchful and expert eye of the public accountant.

But private financing, small or grand, flows most freely when investors believe they have access to good evidence of a company's performance. By allowing the investing public, and not just the privileged classes, to make informed investment decisions, that transparency disciplines management and fuels competition for capital based on the achievement of real success. It is the essence of American economic success.

In our growing and increasingly complex economy, the amount and complexity of information relevant to informed investment decisions is greater than ever. Accounting and auditing are thus more important to American society than ever.

I. The Audit Faces a Challenge to Innovate to Meet Investor Needs.

As Chairman of the PCAOB, I spend most of my time listening. People talk to me about the value of the audit; about whether auditors are happy; whether auditors have the right skills or perform the right procedures; how important missed procedures are; whether skepticism matters, and how do you observe it; whether the auditor should second-guess management, and if so how far should the auditor go.

I hear much from preparers — management and members of boards of directors — and auditors themselves. Their views are often aligned, although not always so.

I also hear from investors. Their voices are quite naturally as dispersed and diverse as they are. They are often not in harmony. Some value the audit and argue for more; others discount the audit as a commodity.

I believe the nub of this commoditization is that it is difficult to observe the full benefit of a good audit. We can't tell which companies would or might have collapsed under management misreporting, but for the auditor's watchful eye. All the public knows comes after an issuer has collapsed, or had to restate materially misstated financial statements, and then the audit is judged a failure.

Let me say a word about that, because there has been some discussion in the press about the term "audit failure." Audit failures are, of course, of great concern to the PCAOB, whether or not the financial statements are misstated, and they are emphasized in PCAOB inspection reports for that reason.

Some have expressed concern that the term "audit failure" could be understood to mean that PCAOB inspectors have determined that the financial statements were incorrect; that is, that the audit must have failed to detect a material misstatement. This is not necessarily the case, and inspection reports have appropriately made this point clear.

Before the audit inspection regime established by the Sarbanes-Oxley Act, an "audit failure" could only be discovered if there were a restatement or other problem in the financial statements. Independent audit oversight and inspections, however, have allowed for new, independent insight into the performance of all audits. In that environment, it is both appropriate and useful to distinguish between a financial reporting failure and an audit failure.

In my view, most people can, in this new environment, understand that distinction. But I also think that a debate over a label needlessly distracts from the critically important substantive point about which there must be no confusion: that the auditor has issued an opinion without satisfying its fundamental obligation to obtain reasonable assurance about whether the financial statements were free of material misstatement.

Whether or not associated with a disclosed financial reporting misstatement, an auditor's failure to obtain the reasonable assurance that the auditor is required to obtain is a serious matter. It is a failure to accomplish the essential purpose of the audit. It means that, based on the audit work performed, the audit opinion should not have been issued, and more work consistent with applicable audit standards was necessary for the opinion to stand.

But the profession needs to do more than just address particularized problems that arise today. The economic crisis that emerged in 2008 has eroded public confidence in the audit's relevance. If audits are meaningful, how could such a crisis occur without the auditors sounding an alarm?

The investing public calls for a stronger basis to trust the audit and a more relevant audit report. The auditing profession must devote attention to these needs in order to maintain its importance to capital markets for the future.

There are also conflicts of interest for the audit to overcome. Regulations have addressed the more obvious ones, such as personal financial interests and business relationships between an audit firm and an audit client. The regulations have also affected the business model, by limiting the scope for audit firms' escalation of commitment to an audit client with dependence on non-audit service fees from that client.

But in some cases, and to some auditors, the audit fee alone represents a significant income stream that anyone would find hard to put in jeopardy. Auditors that blow the whistle are more likely to lose that account. Research shows that 50 percent of whistleblowing auditors lose the client shortly after the fraud revelation. In contrast, only 14 to 15 percent of audit firms lose their client when they are not the one to uncover or reveal the fraud.[3]

II. Audit is a Declining Portion of Accounting Firms' Business Models.

To be sure, audit firms are innovating, but not in the area of the audit. Audit fees have become a decreasing portion of audit firms' revenues. Audit practices have shrunk in comparison to audit firms' other client service lines — not all of which depend on the fundamental exercise of skepticism.

The Sarbanes-Oxley Act puts the audit committee in charge of retaining the company's auditor, and yet the audit committee has limited information on which to judge audit quality. Thus the primary battleground for market share becomes price.

Let me give you some statistics. From 2006 through 2011, 418 companies in the Russell 3000 index changed auditors. The median change in audit fee reported by these companies in their filings with the Securities and Exchange Commission was a decrease of 11.5 percent. A clear majority of the companies that changed auditor — 62 percent — reported a decline in fees for the first year of the new engagement. (Fig. 1 and 2)

Among the 418 that changed auditors, the decline in audit fees was even more pronounced for large engagements, for example those with audit fees of $3 million or more. Eighty-three percent of those companies reported lower audit fees in the auditor's first year, with a median decrease of 15.7 percent.

In comparison, the year-over-year change in audit fees among the full Russell 3000 was essentially flat, with about half reporting increases and half reporting decreases.[4]

Not surprisingly, the fight for market share becomes the fight for incumbency. The annual rate of auditor changes declined each year from 2006 to 2011. Among companies in the 2010 index, only 1.88 percent changed auditors in 2011, compared to 3.72 percent in the 2006 index. (Fig. 3)

By no means is it the role of the PCAOB to regulate audit fees. Nevertheless, the facts are concerning.

It is not the custom for companies' statements to explain the rationale for why a new auditor charges a lower fee than the previous auditor. Is the new auditor more efficient? Did the new auditor reduce the scope of the audit? Did the fee for the new audit cover the full cost of conducting the audit in the first year?

Whatever the answers are in particular cases, the emerging reality for all of us is the need to understand the effect of these trends and pressures on audit quality.

III. The PCAOB's Initiatives to Enhance the Relevance and Reliability of the Audit

The PCAOB is engaged in several initiatives to enhance the relevance and reliability of the audit and refocus market participants on the importance of the quality of the audit, as opposed to merely the price.

1. Performance Standards

First, we have improved and are closely monitoring compliance with several fundamental performance standards to make audits more reliable.

We have recently commenced the 2014 inspection cycle, which includes evaluating compliance with our standards on the use of risk assessment throughout the audit, from planning through the gathering and evaluation of evidence.

We have also recently issued a report on compliance with our standard on engagement quality review, which replaced the profession's concurring partner requirement. The point of an engagement quality review is to catch deficiencies in the audit, much as our inspectors do, except before the report is issued and thus before investors can be harmed by an unreliable audit opinion. The report discusses common inspection findings to promote better execution.

PCAOB inspectors will soon begin evaluating compliance with the PCAOB's new standard to enhance auditors' communications with audit committees, with a view to developing a similar report on compliance trends.

We are also engaged in several new standards-setting projects. I expect soon to ask the Board to vote on a staff recommendation to improve the standard on auditing related party transactions. This is based on two rounds of thoughtful public comment.

The PCAOB is also considering potential changes to the auditing standards on fair value and estimates, use of the work of other auditors and specialists, and quality control, among other topics.

2. Auditor Transparency

We are also working on measures to address the problem that, today, many people see the audit as a commodity that can be produced equally well by any team from any firm with a recognized name. To do so, we've got to provide markets more information about the audit.

The PCAOB has proposed that engagement partners, and other firms, involved in an audit be identified in the audit report. Other countries already have such disclosure. It allows the market to reward audit committees that choose audit partners with a demonstrated record of reliability and to give others an incentive to establish one.

Knowing the name of the engagement partner on an audit, and the various other firms that participate in a global audit, is just a start. But it may help the audit committee conduct appropriate vetting based on objective benchmarking across firms.

We are also developing other indicators of audit quality, both at the engagement and firm level. Expect to see a concept release seeking public comment on potential measures later this year.

The proposal to require disclosure of engagement partner names has generated considerable debate. Auditors in Europe have long signed their audit reports, to no apparent harm to the auditors involved, even when those audit reports have also been filed here in the U.S. with the Securities and Exchange Commission.

But some here have argued that engagement partners are already held accountable to multiple parties, including their firms, audit committees and even investors, and that firmwide quality controls already provide for consistent performance across engagements.

While inspectors do find outstanding quality in some cases, inspectors also routinely find situations where firms' quality controls do not ensure consistently high performance, particularly in areas that have a pervasive effect on quality, such as professional skepticism.

And some quality control concerns can be particularly challenging to remediate, especially in very large firms with thousands of professionals. Lack of professional skepticism appears to be one of them.

Inspectors have also found situations where engagement partners who presided over deficient audits were not held accountable, and were even assigned more challenging engagements.

If this were transparent, the market would be able to provide a discipline on partner selection, as it has in other countries.

On a personal level, I can understand the resistance to releasing information. Yet such transparency is common and effectively used in many settings and professions, including directors and senior management charged with corporate governance at audit clients.

3. The Auditor's Reporting Model

Last year, the Board also proposed the first significant changes to the auditor's reporting model in more than seventy years, based on investors' calls for more informative, insightful and relevant audit reports.

The proposal is based on more than a year of outreach to investors, auditors, preparers, academicians and others, on what kind of changes would be most useful and achievable. The outreach suggested a range of possibilities, from a new, stand-alone auditor's discussion and analysis of the financial statements all the way to some relatively small, but helpful clarifications to the standard auditor's report.

The PCAOB proposed a middle ground approach. It builds on the pass-fail report but would provide more insight about the audit, to help the public understand where the audit was most challenging and thus provided the most value.

The proposal provides a framework to report critical audit matters, which keeps the auditors in their area of expertise — the audit. The proposal would also require auditors to report on their evaluation of certain other information, besides the financial statements, such as the company's annual report and management's discussion and analysis.

We are fortunate to be able to observe changes occurring across the ocean. The U.K. began requiring expanded audit reports earlier this year for companies that apply the U.K. Corporate Governance Code, which includes for example the FTSE 350 companies. Early experience has drawn praised from investors, auditors and issuers.

Based on review of the first 64 FTSE 350 companies that filed the expanded audit opinions, there is no evidence that the additional auditor discussions have had a negative impact on the audit process.

The auditors did not require additional time to issue an audit opinion. The new audit opinions were issued on average in 57 days for the observable group compared to an average of 58 days for their prior year's opinion. Preliminary data does not seem to indicate a significant increase in fees either.

Moreover, I was encouraged to see that the discussion in the new auditor reports appears to be meaningful, not boiler plate. U.K. auditors are now required to discuss in the audit report the assessed risks of material misstatement that that had the greatest effect on the overall audit strategy, on the allocation of resources in the audit and on directing the efforts of the engagement team.

Among the 64 audit reports, there was variation in the risks discussed and how they affected the audit. The number of risk topics discussed in the audit reports ranged from one to eight, with an average of four. (Fig. 4 and 5)

Last month, the PCAOB held a public meeting on our own proposal, and invited U.K. investors, auditors and issuer representatives to speak to that experience. [5]

To give you a sense of the enthusiasm for expanded reporting, let me read to you what Tony Cates, Head of Audit at KPMG U.K., reported —

in 20-odd years of auditing, I've never had so much . . . interest from investors in what I'm doing and . . . emails out of the blue from people saying this is a really positive thing. And much more engagement with investors as a whole. Not on specific companies, but as a whole. And I can only see that as a real positive.[6]

The same week as our public meeting, coincidentally, the European Parliament voted to adopt a broad package of audit reforms for EU companies, including expanded audit reports.

This is an engaging debate of the first order, with important implications for audits, corporate reporting and capital markets. Anyone interested in the public policy of financial markets will find in the record of that April meeting something of interest.

* * *

This is a critical time to protect and champion the audit, and by doing so renew the compact of this generation with the next, as your mentors and forbears did for you.

Many in the profession have come forward, with ideas for the future and an open spirit. Others still tarry: caution dominates, expressed as concerns for cost, and concerns for vague impressions that expanding the audit could expand liability as well.

Our liability system has never brought our markets to their knees. Inadequate warnings to investors have, time and time again.

As Sandy Burton, the Commission's one-time Chief Accountant and later Dean of Columbia Business School once said —

Both currently and historically, the accounting profession has exhibited a comfortable, conservative commitment to the status quo in the absence of an external stimulus for change.[7]

He held "that all changes seem several times more significant and more threatening when viewed in prospect than in retrospect." That is, "Once the reality is faced, it is generally neither so monumentally different nor so threatening as it originally appeared."[8]

Let us go back to de Tocqueville's observation: we are a people "perpetually striving, in a thousand ways, to improve." If the audit is to prosper, de Tocqueville's maxim must be its animating force.

[4] The change in audit fee is the difference in the amount reported by the issuer for its fiscal year audit associated with an index year and the amount reported for the following fiscal year (index year +1). For example, for issuers in the 2006 Russell 3000 Index, the change in fees is for the amounts associated with the 2006 and 2007 fiscal year audits.